Record S&P 500 Runs Away From Mutual Funds Trailing Index

Fund managers, flush with $4.7 billion in fresh cash, are running out of options to catch up with the Standard & Poor’s 500 Index after trailing the measure’s record rally.

The biggest advance for the U.S. benchmark gauge since 2011 is occurring in a year when declines in small caps and technology companies have left fewer equities beating the index than any time since 1999, data compiled by Leuthold Group LLC show. The average stock measured by the Value Line Arithmetic index is up 4.4 percent this year, half as much as the S&P 500.

Desperation to close the gap may be underpinning purchases that sent the S&P 500 up 8.4 percent since Oct. 15, according to Jim Welsh, who helps oversee $5.5 billion at San Francisco-based Forward Management LLC. Eight out of 10 U.S. stock funds focusing on large growth companies are trailing their benchmark index, the second-highest proportion in a decade, data compiled by Morningstar Inc. show.

“All of a sudden it’s like ‘Holy Moses, we’re back at highs, I’m lagging, I’ve got to do something,’” Welsh said in a phone interview on Oct. 31. “The only way you’re going to pick up performance is by being fully invested.”

Stocks rallied around the world for a second week amid signs the global recovery is on track. Pushed up after the Bank of Japan unveiled new stimulus, the S&P 500 rose to a record 2,018.05 on Oct. 31, erasing a decline that swelled to 7.4 percent over the past two months. The index climbed 2.3 percent in October and is up 9.2 percent for the year. It slipped 0.1 percent at 10:53 a.m. in New York.

Missing Out

It’s the fourth time in 2014 the S&P 500 has fallen 3.5 percent or more and recovered in about a month. The rebound encouraged people to send cash to managers. Money flowing to equity mutual funds totaled $4.7 billion in the week ended Oct. 22, the biggest inflow since November 2013, according to data from the Investment Company Institute in Washington.

While the advance to an all-time high is good news if you own index funds tracking the S&P 500, clients of active managers are trailing. More than 75 percent of funds that spread purchases among the largest value and growth companies had gained less than their benchmark measure as of Oct. 29, according to Chicago-based Morningstar.

Funds focused on smaller companies suffered as the Russell 2000 Index slumped 13 percent from a record reached in March. More than 87 percent of the mid-cap funds lagged behind behind their benchmark measures and about half of those focusing on small caps trailed, Morningstar data show.

Hedge Funds

The HFRX Equity Hedge Index, which tracks returns by hedge funds, added 0.4 percent this year through Oct. 30, about 5 percent of what an investor would have made by buying the SPDR S&P 500 ETF Trust.

One reason is that fewer stocks are posting gains that match the biggest indexes, according to Doug Ramsey, who helps oversee $1.7 billion as chief investment officer of Leuthold in Minneapolis. In the S&P 1500 Composite Index, only about 30 percent of companies beat the S&P 500 in the 12 months through September, the fewest since 1999, his data show.

Losses are widespread in small-cap and technology shares. About half of the stocks in the Nasdaq Composite Index have fallen at least 20 percent from their 52-week highs, while more than 40 percent of the Russell 2000 are stuck in bear markets.

“The S&P 500 is masking what’s going on underneath the surface,” said Ramsey. “It makes it much more difficult for active managers to keep up.”

’Liquidity Picture’

Global equities jumped for the ninth time in 11 days on Oct. 31 after the BOJ boosted its target for enlarging the monetary base to 80 trillion yen ($724 billion) from an earlier range of 60 to 70 trillion yen. A day earlier, the Commerce Department said U.S. gross domestic product grew at a 3.5 percent annualized rate in the third quarter.

“Another central bank stepping in really helps the liquidity picture,” said Lars Kreckel, a London-based global equity strategist at Legal & General Investment Management, which oversees about $728 billion. “It does wonders for the global risk appetite. Clearly the growth scare we had earlier in October was overdone.”

Rising volatility will bring active investing back in favor, said Rich Weiss, the Mountain View, California-based senior portfolio manager at American Century Investment, which oversees $140 billion.

“The bull market is getting long in the tooth,” Weiss said. “The next three, five years are not going to be as easy. You’ll see a significant reversal in the success of passive strategy versus active strategy because sector rotation and stock picking will overwhelm what otherwise is going to be a naive strategy of buying everything.”

Hated Rally

Picking winning stocks is hard when so many are failing to keep up with benchmark measures. It’s even harder when stocks that managers avoided rally. That’s what happened with utilities, which according to Goldman Sachs Group Inc. were the most hated group in July.

Utilities, which pay out 3.4 percent of their stock price as dividends for the second-highest yield after phone companies, have gained 20 percent this year as geopolitical tensions and concern over global growth prompted investors to seek safe-haven stocks. The only group that has posted better returns is health care, which jumped 21 percent.

At the same time, money managers were caught off guard by the rotation out of some of the biggest winners. Consumer discretionary stocks such as Priceline Group Inc. and Target Corp. were most favored by mutual funds at the beginning of the second half, a July 11 report by Goldman Sachs showed.

Wrong Bets

The industry, which led the S&P 500 with a 322 percent gain from the bear market’s bottom through 2013, is up 1.9 in 2014, poised for the first year of underperformance since 2007. Priceline is up 3.8 percent this year, while Target has fallen 2.3 percent.

Energy is another group where a sudden rotation surprised investors. The S&P 500 Energy Index, which beat all but one industry during the first six months of 2014, plunged as much as 20 percent from its June high as money flowed out of commodity shares amid a collapse in oil prices. The group is now the worst performer, losing 1.6 percent this year.

“The selloff we saw in October got a lot people too defensively positioned,” Thomas J. Lee, co-founder and managing partner of Fundstrat Global Advisors LLC in New York, said in a phone interview. “In the next two months, we’re going to see people add a lot more risk and that’s going to help the market rise.”